– more aptly titled –
“How do I turn that lump of 401(k) money into a monthly income to pay my bills for the rest of my life?”
It wasn’t that long ago that when someone retired they received a pension. A pension was for a fixed sum that came to the mailbox once a month for the rest of their lives. In 1978 when the law that enabled the 401(k) plan came into being, almost 50% of all workers had a pension. As more and more companies became aware of just how much providing pensions would really cost as workers retired younger and lived longer, they started to figure out ways to shift the burden of paying for retirement to the employee. Presently, only about 14% of all workers are covered by a pension.
Along with reduced pensions and the shift of savings responsibility from the employer to the employee, another large problem came along. That problem was a lack of knowledge by the employer and/or the employee of just how much an employee needed to save in order to accumulate enough money for financially successful retirement. Things have been further complicated by the complete lack of education on how to save, along with how much to save, for a successful retirement.
So where are we now? It has been more than 35 years since the 401(k) was introduced. A small portion of the clients that are getting ready to retire and seeking the advice of financial planners will have either a pension or a partial pension when they retire. Almost all have money in a 401(k) plan. Most of the people I speak with have savings of anywhere from $100,000 to around $1 million. Ironically, how much they have saved does not seem to directly correlate with how much they have earned.
I was working for a bank when the 401(k) was introduced. As a young banker, already covered by a pension plan, I wasn’t too concerned about what a 401(k) had to offer. The 401(k) was introduced as a way to save “extra” money for your retirement. At that point I was far more worried about having enough money to pay my bills each month than trying to save “extra” money – for anything. I had no way of knowing that in a few short years the pension plan would be gone. Even when the pension plan was replaced, there was no emphasis placed on the fact that now I was the one responsible for my retirement. Certainly there was no guidance on how much I would need to save to have any type of retirement at some point in my life.
Because of all that I have a great deal of empathy for anyone that comes to me with the question, “Do I have enough money to retire?” How does anyone really know the answer that question?
About 10 years ago my older clients started coming to me with thoughts that they were about ready to retire and wanted to know how to set up a retirement income. In short, they had been accumulating money all of their lives and now they were ready to start using that accumulation to pay their real-world expenses. My training in that area was weak, so I started to check for resources to get caught up on the subject. I soon found out why my training was so weak. Almost no one had really done any research on how an individual could take a lump sum of money and turn it into a cash flow for the rest of their lives. About all the work that had been done in the past was handled by pension plans and insurance companies. As most people know, most of the time these two sources have really meant insurance companies. Unfortunately, the monthly paycheck generated by the insurance companies was usually fairly low and potential retirees needed more cash flow. The idea of turning a lump sum into a monthly cash flow that would last an individual or couple for the rest of their lives, without turning the money over to someone like an insurance company, had not been well developed.
There have always been wealthy individuals that were able to use periodic withdrawals to provide income that would support them, but these individuals really had no danger of running out of money. Since my clients would face a real risk of depleting their money before they died, I needed more information.
I started out by examining how the insurance companies were able to give a guaranteed amount of income to individuals for the rest of their lives. Pretty much it all boiled down to two things: higher than normal fees and pooled risk. The fees guaranteed their service would be profitable and the pooled risk meant that as long as they had enough people in their program, no individual customer would ever run out of money. You have to remember, though, that the concept of pooled risk means that if a customer dies early, say 6 months after retiring, the rest of the money stays with the insurance company to fund the pool for other people that will live past their life expectancy. Most individuals love the idea that they cannot outlive their money, but are not enamored by the fact that if they die early the insurance company gets to keep their money instead of their heirs!
Over the past few years we have started to see a myriad of new “concepts” about how to live off of your money. The one we are most familiar with probably is the 4% withdrawal rate. The idea here is that if you had a portfolio that was 50% stocks and 50% bonds, you would be able to withdraw an amount equivalent to 4% each year plus inflation and would have a high certainty you would never outlive your money.
Since the last crash of the stock market and the economic downturn, interest rates have been so low that one of the leading thinkers on the subject is suggesting that the rate be lowered to 3%. That means on a $1 million portfolio you would have to live on $30,000 per year. So much for feeling wealthy because you are a millionaire!
There are several other theories out there. One says that you should put your money into 5 buckets. Each bucket is designed to last 5 to 7 years and you are not allowed to take any money from the other buckets until the time has elapsed. The idea behind this theory is that the money that is segregated in the outlying buckets can be invested far more aggressively because it has time to ride out the ups and downs of the market.
Other theories tend to deal with some other facets of retirement such as the thought that many people will actually spend less in retirement than we believe. Some studies purportedly show that even including medical expenses, overall retirement expenses drop significantly as we age. Others ideas deal with concentrating more on the first decade after retirement. The theory here is that what happens in the first decade can significantly affect how much money will be available for the rest of retirement. The results are obvious. If there is a severe turn down during the first decade of retirement it will have a large impact, but if your entire portfolio is conservatively invested for the first 10 years and the market has significant upturn during that time, you have needlessly lowered your standard of living for your entire retirement.
So where am I now?
I believe your retirement income really has 2 parts. The first part consists of your core expenses. These expenses are what you need every month just to live your life at your basic lifestyle. Good examples are utilities, food, what it cost to keep a roof over your head, basic medical expense, auto expense, all your insurance coverages, etc. These are the things that you really need to pay no matter what. These expenses are your “core” expenses. You need enough money automatically coming to you each month to cover these core expenses.
The 2nd part of your expenses are things that you either know or believe you will need on an irregular basis. These consist of things like replacing your car, a new roof on your home, or remodeling your kitchen. Normally with this type of expense, you have the luxury of being able to choose when to pay it.
With these two types of expenses, you need to decide what the lowest amount you ‘could get by on’ is, and what amount would be ideal. Now you have a range of expenses that goes from bare-bones to wonderful.
Once we have a range of expenses, we can design a starting place for your retirement based on all of your income sources and all of your expenses. If the assets and income are reasonable when compared to the expenses, we can use existing computer programs to design a program with a high probability of success. We have to remember, though, that this is only a starting point. The analysis needs to be redone on a regular basis, with updated facts. If need be, we must make adjustments. Our goal is to remain within the parameters of assets, cash flow, risk, and expenses.
What all the research has proven so far is that no one really knows. No one knows what the stock market will do. No one knows what the bond market will do. No one knows what the economy will do. And I think we can all agree that no one knows what our government will do!
With this really means is there is no perfect program you can select right now that will set up your retirement for the next 30 to 50 years. Think back to 30 years ago – could you have predicted what would happen? It also means that what really needs to done is to continually manage your financial life to make sure you stay between your bare-bones expenses and your dream expenses. Your retirement is just like your working life. It is going to take twists and turns. Sometimes your income will be higher than others – sometimes it won’t. Sometimes you will have extra money to do a bit more travel or splurge on something extra. There will also be times when you have to tighten your belt and do with a little less.
I like to think of your retirement like driving down a highway with a clear centerline and those little markers along the edge of the highway that drive you crazy when you get too close to the edge. My job as an advisor is to keep you on the highway. We can move from side to side on the highway and know we will reach our destination safely.
We must set up parameters and understand that changes will happen. We don’t know what we don’t know, and we never will. Therefore, we can only work with what we know now and change it as we go along. As long as you the client and the planner work together, and make small changes when we hit the markers on the edge of the road, we can avoid running the car off the road and into the forest of total destruction.
No magic, no crystal ball—just solid management.